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The role of announced exchange rate policies on exchange rate pass-through to consumer prices in an oil-based small open economy

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Abstract

Most central banks have now recognised price stability as the ultimate goal of monetary policy. In a small open economy with a liberalised capital account and a form of flexible exchange rate regime, achieving price stability requires lowering the exchange rate's impact on consumer prices. In this spirit, this study investigates the role of announced exchange rate policy on the exchange rate pass-through to consumer prices in Nigeria using a structural VAR identified with sign-and-zero restriction. Overall, the study finds that when exchange rate policy interventions were anticipated through an announcement, the exchange rate pass-through to inflation tends to reduce by 12.81% (7.3ppts) from 57 to 49.7%. The estimates also indicate that the exchange rate pass-through in Nigeria is incomplete, moderate, and slow. This suggests that when exchange rate depreciation is well-anticipated, interventions that allow the exchange rate to depreciate will lead to lower inflation than a similar depreciation that is unanticipated. Therefore, one policy implication of these findings is that, in the face of external shocks when exchange rate depreciation is well-anticipated, allowing depreciation can forestall further reserve losses at a lower inflationary cost than similar unexpected depreciation would deliver. The results also imply that effective communication can reduce exchange rate pass-through to consumer prices in Nigeria.

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Data availability

The data supporting this study's findings are available in Federal Reserve Bank of St. Louis Economic Data, IMF International Financial Statistics, and Central Bank of Nigeria Repositories.

Notes

  1. Following Haincourt (2018), this study defines ERPT as “the elasticity of inflation to exchange rate changes” to allow for empirical estimation.

  2. Exchange rate changes in Nigeria can largely be conceived as resulting from the effects of the international oil prices (or other capital flows) on the international reserves, given the central bank's policy response. For instance, a higher foreign currency inflow resulting from, say, an increase in the international crude oil price may be saved by the central bank to allow higher international reserves accretion or allow the exchange rate to appreciate. On the contrary, falling inflows, say, from (a temporarily) declining oil price, may cause a decline in the international reserves if the central bank’s policy response seeks to prevent depreciation. In the case of a permanent decline in oil price, the central bank may allow the naira to adjust, often with some delay. Gleaning from developments in the international oil market or capital flows, it is, therefore, possible for economic agents to anticipate a change in the exchange rate before the announcement of (a policy of) adjustment of the exchange rate. The novel idea in this study is identifying the effects of anticipated change in the exchange rate (adjustment) and the delay in allowing the exchange rate adjustment on the size of the ERPT.

  3. This is because partial prices adjustments will occur even before the actual change in the exchange rate, so that when the actual depreciation eventually occurs, the pass-through effect of such change would be smaller.

  4. However, researchers have shown that even anticipated policies affect inflation, stock price, output, and employment (Mishkin 1980; McGee and Stasiak 1985; Gottschalk and Höppner 2001; D'Amico and King 2015). Also, Mishkin (1980) and D'Amico and King (2015) find that anticipated policy actions have a larger impact than unanticipated; while Xiao and Pang (2017) show that the effect of the unanticipated monetary policy was significantly larger in the Chinese Real Estate Market.

  5. i.e., the magnitude of ERPT is highest to import prices and then to producer prices, and is lowest to consumer prices.

  6. Sign-restriction identification strategy does not require determining the sequence of causation in the model (Breitenlechner et al. 2019; An and Wang 2011).

  7. This study prefers SIC to AIC because SIC penalises larger models and selects more parsimonious models. Hence, the reliance on SIC ensured that a more parsimonious model was used for the estimation.

  8. Nigeria practised managed float system, which involved manipulating the foreign reserves to ensure the value of the naira stays within a particular level or value. This involves buying or selling foreign assets (or currencies) to influence the value of the naira relative to foreign currencies. When CBN intervenes to smoothen temporal pressures on the exchange rate by purchasing or selling foreign assets (currencies), the size and composition of the net foreign asset (NFA) change. Hence, changes in NFA represent close observable exchange rate management policies. Also, several studies use the NFA as a proxy for exchange rate management policies (see; Adebiyi 2007; Sarno and Taylor 2001). Hence, in the spirit of these studies, this study proxies the policies with NFA.

  9. The PT is calculated as \(\frac{-1.14}{2.o1\%}\times 100\) = − 57%; the PT is median as BVARs do not produce unique estimates. See, An and Wang (2011) and Zubair et al. (2013) for a detailed description of the pass-through formula.

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Authors and Affiliations

  1. Department of Economics, Ahmadu Bello University, Business School, Zaria, Nigeria

    Jamilu Iliyasu & Aliyu Rafindadi Sanusi

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  1. Jamilu Iliyasu
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Aliyu Rafindadi Sanusi conceptualised the approach, interpreted and discussed the empirical findings, reviewed the text in its entirety, and contributed to the writing of the introduction. Jamilu Iliyasu conducted the estimation and drafted the initial drafts of the introduction, literature review, identification of the VAR model, and conclusion of the study's section.

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Correspondence to Jamilu Iliyasu.

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Iliyasu, J., Sanusi, A.R. The role of announced exchange rate policies on exchange rate pass-through to consumer prices in an oil-based small open economy. SN Bus Econ 3, 10 (2023). https://doi.org/10.1007/s43546-022-00391-3

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